Difference in value[edit] · An in the money (ITM) call option on a stock is often exercised just before the stock pays a dividend that would lower its value by more.
Table of contents
- How to identify if a particular option contract is American or European style?
- European Options
- Stock Options and Index Options, an Illustrated Introduction with Examples
- American Option
The option ticker symbol ranges from 17 to 21 characters, depending on the ticker symbol of the underlying security, and consists of the following components:. GOOG 14 04 19 C However, many brokers use a simplified expression to represent the option, which varies among brokers. Because options contracts are continually created and destroyed, open interest, unlike the number of shares of stock, fluctuates widely.
At expiration, all contracts of that class are extinguished. Note that, in general, the greater the strike price is from the stock price, the smaller the open interest and the fewer the trades. In fact, many of the volume values have no number because there were no trades for that day. If the price of the underlying stock should change by a large amount, then more options with strike prices clustering around the new price will be written, and options that were clustered around the old price will either be closed out or exercised, thereby decreasing the open interest, or there will be fewer trades for those options.
In addition to options, the OCC also offers clearing and settlement for futures and options on futures. Its website publishes statistics and news on options, and publishes all changes in the trading rules and any adjustments of option contracts that requires changes, such as a merger of companies whose stock was the underlying security to the option contracts. The OCC is the direct participant in every purchase and sale of an option contract.
When an option writer or holder sells his contracts to someone else, the OCC serves as an intermediary in the transaction. The OCC issues, guarantees, and clears all option trades involving its member firms, which includes all U. An option holder exercises his option by notifying his broker of his intention to exercise. Moreover, on the last trading day for the option, notification must be given before the exercise cut-off time , which will probably be earlier than on trading days before the last day, and the cut-off time may differ for different option classes or index options.
How to identify if a particular option contract is American or European style?
Brokers generally require notification to exercise an option, even if it is in the money. After notification, the broker sends the exercise instructions to the OCC, who then assigns the exercise to one of its Clearing Members who are short in the same option series as is being exercised. The Clearing Member then assigns the exercise to a customer who is short in the option. The customer is selected by a specific procedure, usually on a first-in, first-out basis. Thus, there is no direct connection between an option writer and a buyer.
To ensure contract performance, option writers are required to post margin, the amount depending on how much the option is in the money. If the margin is deemed insufficient, then the option writer will be subjected to a margin call. Option holders don't need to post margin since the option will only be exercised if it is in the money. Moreover, options, unlike stocks, cannot be margined.
Because the OCC is always a party to an option transaction, an option writer can close out his position by buying the same contract back, even while the contract buyer retains her position, because the OCC draws from a commingled pool of contracts that lack any connection to the original contract writer and buyer. The OCC buys the contract, adding it to the many other option contracts in its pool. Sarah Call-Buyer buys a contract that has the same terms that John Call-Writer wrote — in other words, it belongs to the same option series. However, option contracts have no name on them.
She instructs her broker to exercise her call, who then forwards the instructions to the OCC, who assigns the exercise to one of its participating members who provided the call; the participating member, in turn, assigns it to an investor who wrote such a call; in this case, it happened to be John's brother, Sam Call-Writer.
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John got lucky this time. Sam, unfortunately, either must turn over his appreciated shares of Microsoft, or he'll have to buy them in the open market to provide them. This is the risk that an option writer must take — an option writer never knows when he'll be assigned an exercise during any time in which the option is in the money. John Call-Writer decides that XYZ might climb higher in the coming months, so decides to close out his short position by buying a call contract with the same terms that he wrote — the same option series.
Sarah, on the other hand, decides to maintain her long position by keeping her call contract until April.
European Options
This can happen because option contracts are fungible. John closes his short position by buying the call back from the OCC at the current market price, which may be higher or lower than what he paid, resulting in either a profit or a loss. Sarah can keep her contract because when she sells or exercises her contract, it will be with the OCC, not with John. Option writers whose contracts expire make the maximum profit possible for their position, which is the premium that they received, and option holders receive the maximum loss, which is the premium that they paid.
Option writers whose contracts were assigned will have earned less than the premium or may well have suffered losses, since the option holder wouldn't exercise it unless it was in the money. A closed out transaction could be at a profit or a loss for both holders and writers of options. A closed out transaction will always yield at least some return of investment, because the investor would not close out his position unless he was getting or saving more than the transaction cost. Stock index options are based on a stock index rather than on specific stocks.
The value of index calls increase as the index increases, and the value of index puts increases as the underlying index decreases. These options are like stock options, but with some important differences. Because these options are based on indexes, there is greater diversification, and usually less volatility than with specific stocks.
Stock Options and Index Options, an Illustrated Introduction with Examples
An index will never drop to zero, and it will never increase as dramatically as some specific stocks can, especially within a short time. Therefore, the risk is more limited, but so is the profit potential. Also, contract adjustments are rarely needed for a stock index. For instance, stock splits of stocks within the index do not affect the index, and thus, no adjustments on the contracts are needed.
These options are settled by the exchange of cash, not securities, which, for obvious reasons, is called a cash settlement.
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The option writer who is assigned an exercise pays cash to the holder who exercised the option. Many index options are European-style options that can be exercised for a short time right before expiration. However, this makes little difference for options that are settled in cash, because the option holder can always sell the option on the exchanges for cash at any time before expiration. The cash that is paid upon exercise depends on the index, which depends on the component prices of the index.
Some contracts have AM settlement and some have PM settlement. In AM settlement , the cash settlement value is calculated using the opening component prices on the day of expiration.
American Option
In PM settlement , closing prices on the day of expiration are used to determine the cash settlement value of the contract. While futures confer the obligation to buy or sell something at a specific price, future options confer the right, but not the obligation, to buy or sell a specific futures contract at the strike price, and is settled in cash.
Foreign currency options confers the right to buy or sell a specific currency for a set amount in dollars, and is settled in U. Thus, it is a way to freeze the foreign exchange rate for a given currency for the lifetime of the option. Foreign currency future options are options on futures contracts for currency rather than the currency itself. Options that are in the money pay the absolute difference between the price of the futures contract for currency and the strike price. The volume for currency futures options is much greater than for currency options. Interest rate options gives the holder the right to buy or sell bonds at the strike price, which can include Treasury bills, notes, and bonds and GNMA pass-through certificates.
Interest rate futures options gives the holder the right to buy or sell futures contracts on Treasuries, municipal bonds, and European government bond futures. The Pauper's Money Book shows how you can manage your money to greatly increase your standard of living. Example: Adjusting Option Contracts for Stock Splits In a 2-for-1 stock split, contracts are usually adjusted by doubling the number of option contracts, and halving their price.
Option Writer or Seller? Multiply call price times the number of shares per contract times the number of contracts. Scenario 2 — Closing Out an Option Position by Buying Back the Contract John Call-Writer decides that XYZ might climb higher in the coming months, so decides to close out his short position by buying a call contract with the same terms that he wrote — the same option series. Thus, the OCC allows each investor to act independently of the other.
Save, invest, and earn more money. Get out of debt. This also makes the pricing and valuation simpler than that of the American option. While the ability to execute an American option at any time during the contract makes it more flexible, it also renders it more expensive. Investors may not have the freedom to choose between these two styles as Sebi has asked the stock exchanges to opt for only one of these.
Once they have chosen an option, they will not be able to switch to the other without the approval from Sebi.
The rising interest rates have made these attractive. Worth the weight? Smooth way to pay. Realty check. Optimistic Indians. American options allow investors to buy or sell a specific asset, such as a stock or exchange-traded fund ETF at a specific price before a specific date. Options to buy a certain asset are known as call options, while options to sell an asset are called puts.